Accounting 101 – Cash vs. Accrual Basis
It’s all in the timing
As a small business owner, it’s important to understand the difference between the two accounting methods, so you can make the best bookkeeping choice for your business. The core difference between the cash method and the accrual method is in the timing of when the transaction is recorded. These timing differences occur in both revenue recognition and in expense recognition. Over time, in theory, both methods are approximately the same. But what does that mean to your books today?
The decision to use cash or accrual accounting can effect your business tax return and ultimately your bottom line. For tax purposes, you will need to make this decision for your business before you file your first business tax return. For more information, see IRS Publication 538 – Accounting Periods and Methods
Timing Differences –
There are potential timing differences in recognizing revenues and expenses between accrual basis and cash basis accounting.
Four types of timing differences:
- Accrued Revenue: Revenue is recognized before cash is received.
- Accrued Expense: Expense is recognized before cash is paid.
- Deferred Revenue: Revenue is recognized after cash is received.
- Deferred Expense: Expense is recognized after cash is paid.
Accrual Basis Accounting Method –
The accrual basis of accounting is the concept of recording revenues when earned and expenses as incurred, regardless of when the money is actually received.
The upside to using the accrual method is it gives small business owners a more realistic idea of income and expenses during a certain period of time. This can provide you (and your accountant) with a better overall picture of how your business is doing and where it’s headed in the future.
One drawback to the accrual method is that it doesn’t account for cash flow or funds that are available in your bank account. If you don’t have careful bookkeeping practices, the accrual-based accounting method could be financially devastating for a small business owner, as your books could represent a large amount of revenue while your bank account is completely empty.
The accrual basis is used by all larger companies, for several reasons. First, its use is required for tax reporting when sales exceed $5 million or your business stocks an inventory of items that you will sell to the public and your gross receipts are over $1 million per year. Also, a company’s financial statements can only be audited if they have been prepared using the accrual basis. In addition, the financial results of a business under the accrual basis are more likely to match revenues and expenses in the same reporting period, so that the true profitability of an organization can be discerned. However, unless a statement of cash flows is included in the financial statements, this approach does not reveal the ability of a business to generate cash.
Cash Basis Accounting –
The cash method of accounting doesn’t take any of these timing difference into account. Simply, revenue is booked when cash is received, and expenses are booked when cash is paid. The cash basis of accounting also does not take into account accounts receivable or payable, since it only applies to payments from clients when the cash is in hand, and expenses when the transaction clears your bank account.
Cash accounting is simpler to remember and record, since it follows your business checking account. When a sale is recorded in your checking account, it’s recorded in your business. But the cash accounting method may not show the real picture of your business activity, since the month you were busy or slow is different from the month when you received the money.
Cash accounting also doesn’t record Accounts Receivable (who owes you money) or Accounts Payable (who you owe money to), so cash accounting does not give you a complete picture of your business finances.
The cash basis is only available for use if a company has no more than $5 million of sales per year (as per the IRS). It is easiest to account for transactions using the cash basis, since no complex accounting transactions such as accruals and deferrals are needed. Given its ease of use, the cash basis is widely used in small businesses. However, the relatively random timing of cash receipts and expenditures means that reported results can vary between unusually high and low profits.
Examples:
Example 1 – Say that you are a wedding singer and charge $500 to perform at a wedding reception.
- Scenario 1 – The customer pays you in May for their June wedding. Under accrual accounting, you haven’t earned the revenue for this gig until you perform in June. In May, you record $500 in cash with an offsetting entry of $500 to a liability, as a deferred or unearned revenue. When you perform in June, you record the revenue as $500 sales and reverse the liability.
- Scenario 2 – You invoice your customer after you perform at their event and allow them one month to pay. You perform at the couple’s wedding in June, but you don’t receive payment until July. Under accrual accounting, you record the revenue as $500 in sales in June, and $500 to accounts receivable, as accrued revenue. When they pay you in July, you record the $500 cash and reverse the receivable.
Imagine if your business was on a cash basis. If you only booked revenue when cash was received, you would have one sale in May and one in July when you actually earned the revenue when you performed twice in June! You would also have no record of who you owed or who owed you in on your balance sheet since you weren’t tracking accounts payable or receivable.
Example 2 – Say you have a company vehicle, and pay car insurance. Your annual policy covers September 2018 this year to August 2019 and is $1.200.
- Scenario 1 – You have opted to pay your insurance premium $300 quarterly, with payments due in Aug 2018, Nov 2018, Feb 2019 and May 2019.
- Under the accrual basis of accounting, you would expense the policy monthly $100 while the $300 quarterly cash payments would offset prepaid expense or accrued expense appropriately. As a result your expense in 2018 would be $400 for Sep-Dec 2018, and your expense in 2019 would be $800 for Jan-Aug 2019. The expenses would match the period the insurance covered.
- Under the cash basis of accounting, you would only show expenses based on the 4 quarterly payments of $300. As a result your expense in 2018 would be $600 for the Aug & Nov payments, and your 2019 expense would also be $600 for the Feb & May 2019 payments. Your year end reports would not reflect that you had prepaid 2 months of expense in 2018 for the following year.
- Scenario 2 – You have opted to pay your insurance premium in one $1,200 lump sum in August 2018.
- Under the accrual basis of accounting, the $1,200 annual payment would be posted to prepaid expense and offset $100 monthly as it was expensed. As a result your expense in 2018 would still be $400 for Sep-Dec 2018, and your expense in 2019 would be $800 for Jan-Aug 2019. The expenses would match the period the insurance covered.
- Under the cash basis of accounting, the full $1,200 expense would be recorded when paid in Aug 2018, thus overstating the 2018 expense and understating the 2019 expense.
While both scenarios are technically correct under their respective accounting methods, the difference in reporting could cause differences in your income taxes. Accrual basis accounting is generally thought to be a more accurate and complete method of accounting which is why it is required by GAAP for larger companies.
